Investing For A Market That Moves Sideways - With SCHD

| About: Schwab U.S. (SCHD)

Summary

SCHD has demonstrated superior performance when the market is moving sideways.

Dividend champions often emphasize repurchasing shares to go along with paying dividends.

The lack of capital expenditures is a challenge for growth companies that depend on generating more sales to grow earnings.

The flattening of the yield curve may further encourage investors to seek SCHD as a source of superior yields.

The current price on SCHD is above my threshold for buying; I see it as a hold.

Some investors worry about the economic impacts of major companies repurchasing shares rather than investing in new productive assets. I see a great deal of legitimacy to those concerns from a macroeconomic perspective because growth in GDP at the national level requires growth in either the volume of hours worked, capital investment, or TFP (total factor productivity). Some people refer to TFP as technology, but the simple argument suggests that our growth as a country suffers from a lack of new capital invested in productive physical assets.

For the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) the sustainability of earnings used to fund dividends is a major consideration. If companies can grow earnings fast enough to grow dividends, SCHD succeeds as a long term investment.

To be clear, I'm not endorsing the current price. I try to add to my holdings in SCHD at prices around $36. The market's current valuations are pretty rich and the difference between buying at $36 and buying at $40 is about 3 to 4 years of dividends. If someone asked for your dividends for the next 3 years, what would you say? I'd clearly tell them to "buzz off", or some less family friendly term.

I plan to have some work coming out over the next week or so to demonstrate some of the macroeconomic implications of the current situation. Despite concerns that massive amounts of share buybacks are a problem, I don't consider those buybacks to be "financial engineering". Two of my favorite investments right now are Wal-Mart (NYSE:WMT) and Target (NYSE:TGT). I own both and have no problem endorsing their current prices. Both are running very aggressive buyback programs and I expect them to be very successful. Between the shares the company is repurchasing and reinvesting my dividends I expect my tiny fractional ownership in the companies to increase substantially over the next couple of years.

Wal-Mart is currently about 3.21% of the SCHD portfolio and TGT is 1.19% of the portfolio.

SCHD is Strong When Markets Trade Sideways

The Schwab U.S. Dividend Equity ETF is great when the broad equity market trades sideways. The SPDR S&P 500 Trust ETF (NYSEARCA:SPY) is my default comparison for success in investment in equities, and investors can easily see the success SCHD has demonstrated over the last year:

Click to enlarge

SCHD easily outperformed the market. While the comparison is fairly arbitrary at choosing a year of history from the current date, it is useful to consider the impact of the yield curve. Despite expecting earnings to be weaker across the broad market the S&P 500 is back to about the same level it enjoyed last summer. I believe that is primarily a function of a lack of alternative investments. The flattening of the treasury yield curve leaves investors looking for a better option for yield.

The following table measures the 7-1 spread and the 10-2 spread at the end of several quarters and then every week or so during 2016:

7 to 1

10 to 2

Q4 2014

1.72

1.5

Q1 2015

1.45

1.38

Q2 2015

1.79

1.71

Q3 2015

1.42

1.42

Q4 2015

1.44

1.21

1/8/2016

1.27

1.19

1/15/2016

1.3

1.18

1/22/2016

1.34

1.19

1/29/2016

1.2

1.18

2/5/2016

1.03

1.12

2/12/2016

0.99

1.03

2/19/2016

1

1

2/26/2016

0.95

0.96

3/4/2016

1.02

1

3/11/2016

1.09

1.01

3/18/2016

1.04

1.04

3/24/2016

1.07

1.02

4/1/2016

0.94

1.03

4/8/2016

0.93

1.02

4/15/2016

0.99

1.02

4/22/2016

1.11

1.05

4/29/2016

1.04

1.06

5/6/2016

1.04

1.05

5/13/2016

0.96

0.95

5/20/2016

0.98

0.96

5/27/2016

0.99

0.95

6/3/2016

0.9

0.93

6/10/2016

0.87

0.91

6/17/2016

0.9

0.92

Click to enlarge

This is a chart I maintain to track the yield curve for investments in mortgage REITs. The flattening of the yield curve is problematic for the mortgage REITs but they rallied despite the flattening yield curve as investors seek higher yields. The 10 year yield on 06/17/2016 was 1.62%. That is less than the 10-2 spread was at the end of the second quarter in 2015.

When GDP Growth is Weak

If GDP growth is weak it will present a larger problem for growth stocks that should struggle to grow sales and earnings. The established dividend champions tend to send more of their capital to dividends and to repurchasing shares. Neither of those is an investment to grow productive capacity, but the dividends accruing to shareholders create a material return.

Conclusion

The reason SCHD is attractive as a long term investment is the ability of the underlying companies to outperform when the market is trading relatively flat. These dividend champions succeed in these environments because they are emphasizing returning cash to shareholders rather than trying to be the ones to grow the economy. My entry target is around $36 per share. I'm already long SCHD and would look to add to my position if shares fall to $36 again.

Disclosure: I am/we are long SCHD, WMT, TGT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.